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Islamic products are available to regular savers, investors and homebuyers,
but unlike standard deals they don't charge interest.
The government has announced plans for Britain to issue a £200m Islamic bond in a bid to attract new money to
London. The bond will be aimed at institutions, but there are Islamic finance
products available to regular savers, investors and homebuyers. Here Here us a
guide to how sharia-compliant funds and mortgages work.
Why aren't regular accounts sharia-compliant?
Central to Islamic Finance is the fact that money itself has no intrinsic value; it is simply a medium of
exchange. Each unit is 100% equal in value to another unit of the same
denomination and you are not allowed to make a profit by exchanging cash with
another person. A Muslim is not allowed to benefit from lending money or
receiving money from someone.
This means that earning interest (riba) is not
allowed – whether you are an individual or a bank. To comply with these rules,
interest is not paid on Islamic savings or current accounts, or charged on
Islamic mortgages.
How do sharia-complaint banking products work?
There are several ways that banks can structure
accounts so that they are sharia-compliant.
Ijara works as a leasing
arrangement: the bank buys something for a customer and then leases it back to
them. Different forms of leasing are permissible, including those where part of
the instalment payment goes toward the final purchase. This might be used to
help you buy a car or other item, or to help a business buy equipment.
Murabaha works by the bank
supplying goods for resale to the customer at a price that includes a margin
above the costs, and allows them to repay in installments. This might be used
to provide a mortgage on a property. The property is registered to the buyer
from the start.
Musharaka is a joint venture in
which the customer and bank contribute funding to an investment or purchase and
agree to share the returns (as well as the risks) in proportions agreed in
advance.
Wakala is an agreement that the
bank will work as the individual's agent. If a saver enters into this type of
agreement, the bank can use their cash to invest in sharia-compliant trading
activities to generate a target profit for them.
How do the banks make money?
Banks can profit from the buying and selling of
approved goods and services. The principal means of Islamic finance are based
on trading, and it is essential that risk be involved in any trading activity,
so banks and financial institutions will trade in sharia-compliant investments
with the money deposited by customers, sharing the risks and the profits
between them.
Islamic banks are structured so that they retain
a clearly differentiated status between shareholders' capital and clients'
deposits in order to make sure profits are shared correctly.
Although they cannot charge interest, the banks
can profit from helping customers to purchase a property using a ijara or
murabaha scheme. With an ijara scheme the bank makes money by charging the
customer rent; with a murabaha scheme, a price is agreed at the outset which is
more than the market value. This profit is deemed to be a reward for the risk
that is assumed by the bank.
There are firm laws governing the types of businesses with which the banks
can trade. There should be absolutely no investment in unsuitable businesses,
including those involved with armaments, pork, tobacco, drugs, alcohol or
pornography.
It's similar to ethical banking, then?
There is some common ground. Some of the tenets of Islamic banking will
appeal to anyone, Muslim or otherwise, who agrees with the underlying
principles of equitable distribution for everyone, the ideals of fair trading,
spending of wealth judiciously, and the well-being of the community as a whole.
In the wake of the banking crisis, savers may also be drawn by Islamic banking's
approach to investment: they can only invest in real assets, not financial
instruments that are based on speculation.
The Move Your Money Campaign rates one
bank, the Islamic Bank of Britain, highly for ethics and customer service, but
its overall score is diminished by a lack of women on its board and high
directors' pay, among other things.
How does it work if I take out a mortgage?
Islamic mortgages, or house purchase plans (HPPs)
can involve ijara, where you are technically
leasing the property from the bank, or diminishing Musharaka, where you buy in
partnership with the bank and your monthly repayments gradually buy it out. As
with a standard mortgage you will usually need a deposit, and you will need to
have the house valued before you enter into the arrangement.
You will also be able to fix the amount you pay
each month if you wish – for example, the Islamic Bank of Britain offers a fixed rental rate of 3.79% to homebuyers with at least 35% to put down as a
deposit, and 4.19% for those with a 20% deposit – both rates are fixed until 31
December 2015.
The bank also offers a buy-to-let house purchase
plan.
How does it work if I open a savings account?
Instead of being offered an interest rate you will be offered a target
profit, which the bank will try and make for you by investing your money in
compliants investments (this might include homes bought through the bank's
Islamic mortgage scheme). The profit is subject to tax, just like interest on
standard savings and current accounts. Because there is an element of risk you
need to agree that you are happy to make a loss.
As with standard savings accounts, you can choose for a fixed-term deal or
an easy-access account. The target rates on offer are along the lines of those
elsewhere in the savings market, and sometimes better – currently, the Islamic
Bank of Britain is offering a table-topping 2.32% on a two - year savings bond, according to Moneyfacts.
Is my money safe?
If the bank is covered by the Financial Services
Compensation Scheme (FSCS), up to £85,000 held on deposit with it will be
protected if things go wrong. Check that it is before you hand over any money.
Practical Example:
I've taken loans from Islamic and non-Islamic banks. They all make money,
but differently.
Let's say you want to buy a car for $10,000, over 5 years.
Non-Islamic bank
The bank says: $10,000 compounded on a Monthly basis over the course of 5 years at a 4% interest rate would be worth: $12,210. They tell you let's make the monthly payment $200.
They calculate the interest every month. Your first payment would be fully interest, your last one would have no interest in it.
During the loan you can:
Let's say you want to buy a car for $10,000, over 5 years.
Non-Islamic bank
The bank says: $10,000 compounded on a Monthly basis over the course of 5 years at a 4% interest rate would be worth: $12,210. They tell you let's make the monthly payment $200.
They calculate the interest every month. Your first payment would be fully interest, your last one would have no interest in it.
During the loan you can:
- Delay a payment (only interest for that is added to the loan, the 5 years increases)
- Take more money on the same loan (Refinance)
- Pay partially or fully.
During the loan the bank can:
- Increase the interest rate (in some places, without telling you, and you keep paying the same $200 monthly but the 5 years increases)
If the rate increases, or any payment is delayed you will pay more than $12,210.
The loan is for $10,000 with interest payments monthly. You don't know if it will finish on the exact date.
Islamic bank
The bank says I will buy the car for $10,000 , would you buy it for $15,000? (I say 15 for simpler calculations, it's usually just a little higher than a non-Islamic bank). We don't call it interest, it's profit.
If you say yes they will buy it. You still have the option to refuse buying it from the bank.
The $15,000 will be split into 60 payments of $250.
During the loan you can't:
- Delay a payment (you have to pay it)
- Take more money on the same loan (Refinance), you can take a new loan.
- Pay partially.
During the loan the bank can:
- Force you to pay a payment.
If you fully pay an Islamic loan before it's completion, most Islamic banks would pay you an "early repayment reward", which would reduce their profit.
The loan is for $15,000 with NO interest payments. You know the exact date when it will finish.
Conventional to Islamic Finance products
The replication and transformation of
conventional financial products into their corresponding Islamic finance
analogues have important implications for the regulation and supervision of
Islamic financial institutions.
First, the various lending structures generate
different risk and balance sheet exposures for Islamic banks that need to be
carefully monitored and managed. For
example, while only a few Islamic financial products generate different
liquidity profiles from conventional products, the lack of uniformity of
standards for “Islamic banking” practices across Islamic countries makes it
difficult to apply the same prudential regulatory standards (e.g., capital
adequacy requirements) across the board. This calls for more harmonization of
Islamic banking practices, which in turn calls for harmonization of Shari`a
standards at the national and international levels.
Second, the treatment of profits/losses
will have consequences for the balance sheet structure and will require
particular adjustments to meet minimal prudential requirements. For example, in mudaraba transactions, the
bank bears full financial responsibility for any losses but shares relative
profits with the client. Any losses
stemming from uncollateralized equity financing may require higher loan loss
provisioning and additional capital.
Mudaraba transactions are essentially investment partnerships in which
all the capital is provided by the financial institution while the business is
managed by the entrepreneur/client.
Profits are shared in pre-agreed ratios, and losses are borne by the
bank (which is passed on to the depositors).
Third, disclosure requirements may need to
be comprehensive and more frequent to inform investors of the investment
techniques, so they can make decisions based on their risk preference. Maintaining clear transparency and ensuring
adequate disclosure of financing mechanisms are important steps towards
building the necessary foundation for Islamic finance. And with respect to firms in which financial
institutions take stakes, greater transparency, along with strengthened
corporate governance, are necessary.
The
market
Though the principles underlying Islamic finance
are as old as the religion itself, modern banks did not start offering sharia-compliant
products until the mid-1970s. Since then it has grown into a global industry,
with total assets of around $2 trillion. Most of that (nearly 80%, according to
Malaysia’s central bank) is entrusted either to Islamic banks or to the Islamic
units of conventional banks. The rest takes the form of sukuk,
Islam’s answer to bonds (15%); Islamic investment funds (4%) and takaful,
the Islamic version of insurance (1%). In 2012 Iran accounted for 43% of the
world’s Islamic banking assets, with Saudi Arabia (12%) and Malaysia (10%)
ranking second and third.
The demand created by this rapidly growing pool
of Islamic capital has spurred the growth of sharia-compliant
products. These take many forms, but none may pay or charge interest, nor can
they invest in things that Islam forbids (so no alcohol, pork, gambling or
pornography). In an Islamic mortgage, for instance, a bank does not lend money
to an individual who buys a property; instead, it buys the property itself. The
customer can then either buy it back from the bank at a higher price paid in
instalments (murabahah) or make monthly
payments to the bank comprising both a repayment of the purchase price and rent
until he owns the property outright (ijara).
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